Understanding Interest Rates

Interest plays a role in almost every aspect of your financial life. If you have student loans, take out a mortgage, purchase a bond, make a purchase on a credit card, or any number of other financial activities, you’re dealing with interest. Understanding interest rates is therefore a necessary part of mastering your finances. If you’re interested in learning more about interest rates and how they impact many everyday decisions, here’s what you need to know.

What is Interest?

At its most basic level, interest is the payment a lender receives for allowing someone to borrow their money.

When an individual takes out a loan, the bank is the lender. If you have a credit card, the credit card company is the lender. When corporations want to raise capital, they can issue bonds. Investors that purchase these bonds are then the lenders. Regardless of who the lender is, the reason the lenders are willing to lend their money is that the borrower agrees to pay an additional amount, this amount is the interest rate.

Let’s look at an example. If an individual took out a $1,000 loan with an onetime interest payment of 5%, the individual has agreed to pay back $1,050. This means the borrower paid fifty dollars to use the money and the lender earned fifty dollars simply by letting the borrower use their money.

The Power of Compounding

So far, it’s simple enough. What makes interest a bit more complicated is that interest typically compounds. That’s because the interest rate is usually charged periodically; annually, quarterly, monthly, etc. Each time interest is charged, you’re paying interest on the principal, as well as any interest previously earned.

Let’s look at the same loan from before, but now let’s say the borrower decided to pay that $1,000 loan back over five years, with an annual interest rate of 5%. The total amount the borrower will now pay the lender is $1,132.27. The borrower now spent $132.27 in interest, more than doubling the amount of interest paid, even though the interest rate remained the same. That is the power of compounding interest.

Factors that Influence Interest Paid

Due to compounding interest, the amount the lender pays in interest is about more than just the interest rate. To calculate the total amount a loan will cost you’ll need to consider the interest rate, the amount of the loan, the length of the loan, and how often interest is calculated.

As the above example highlights, the length of the loan matters. The longer the loan, the more time there is for interest to compound, and the more the borrower pays in interest. While the length of a loan is an important factor, the amount of the loan is important too. For example, mortgages (loans for homes) may result in a high amount of interest paid, even if the interest rate is relatively low since a home is both expensive and the length of the loan is usually fairly long (typically fifteen or thirty years).

Interest When Borrowing

When you’re the one borrowing money, compounding interest costs you more. This is why debt management is such an important part of managing your finances. Taking on debt is not necessarily a bad thing, but not all debt is created equal.

Some debt has relatively low-interest rates and can help you increase your net worth in the long run. Two types of debt that often fall in this category are student loans and homes. Student loans allow you to earn a degree, which can help increase your earning potential and home has the potential to appreciate, meaning you can sell it for more than you paid for it.

But some debt comes with high-interest rates and provides no opportunities for increasing your net worth. The best example of this kind of debt is credit card debt. With this type of debt, you can even end up spending more on interest than on the principal. Paying off this type of high-interest debt is one of the best things you can do for your financial health.

Interest When Lending

When you’re the one borrowing money, high-interest rates mean you spend more money. When you’re the one lending the money, high-interest rates give you the chance to earn more money. While many people associate lending money with banks, individuals can also lend money. One of the simplest ways to do this is by investing in bonds. When you purchase a bond, you’re allowing the issuing entity to borrow your money, in exchange for them paying you interest.

The Takeaway

Interest is not innately good or bad, but it is an important part of many financial transactions. Therefore, an understanding of interest rates is the key to making informed financial decisions.

Related Courses: Interest Rate Modeling

Learn the essential mathematics for term structure modeling and interest rate derivatives valuation in an accessible and intuitive fashion. Understand and apply the various approaches to constructing yield curves. Build interest rate models in discrete and continuous time.

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